Market Outlook | November 26, 2012

“The wisest mind has something yet to learn.” (George Santayana 1863 - 1952)

Familiar unease

For about three years, common macro-related fears persisted in various financial market conversations. Those worrisome topics stretched from slowing corporate earnings, to a complex cleanup of the European crisis, to decelerating emerging markets. Today, no clarity or certainly exits on these big-picture topics; thus, participants are left to balance their views between collapse and, hopefully, rally. Finding the middle ground is less thrilling, more nuance-oriented and most likely closer to the truth than a simple statistical summary. Plus, the interconnected themes, which are worth tracking for observers and participants, can easily shape and form a consensus perception. Yet, the fears of fundamental and macro concerns are exhausted and dramatic shifts are short-lived.

The last two months demonstrated the suspense of all key macro events and a breather among risk-takers. Yet, risk-takers do not sit on the sidelines long enough, as that would go against human nature. Eventually, money has to be invested somewhere. Betting on upside surprises is still more intriguing than betting on the collapse of known macro issues. As a start, GDP is expected to be revised higher in the US, supporting the building argument of an improving economy. Eurozone concerns may me overstated in some cases, as the German economy is showing signs of recovery and is not as bad as advertised. After all, the German DAX Index is up nearly 24% this year as the leading European economy. Certainly, the thought of Eurozone collapse may linger in headlines, but actual results are not clear-cut. Finally, overall market volatility remains tamed as the low interest rate policy remains in place. This suggests that markets may turn out more stable than the many conventional stories told.

Revisiting old ideas

Five years ago, the themes of housing and emerging markets were favored among fund managers. In both cases the bubble was forming before its eventual burst in 2008. Now, the questions of lessons learned are deliberated by historians, but forward-thinking observers are noticing that history is digested faster than imagined. While most concluded that risk in housing is not fruitful or plausible, the recent trends suggest otherwise on a broad level. The housing recovery in this new era (post-2008) makes a tangible and strong argument for revival. The Federal Reserve Chairman addressed the following point:
“Recently, the housing market has shown some clear signs of improvement, as home sales, prices, and construction have all moved up since early this year. These developments are encouraging, and it seems likely that, on net, residential investment will be a source of economic growth and new jobs over the next couple of years.” (Ben Bernanke, New York Economic Club, November 20, 2012). Of course, sustaining this housing recovery is an uphill battle, which is addressed by economists and analysts alike, especially since the bounce was somewhat inevitable from depressed levels. Nonetheless, momentum is powerful, especially in a world with limited ideas with a compelling growth story. Investors in homebuilders (XHB – Homebuilders Index) have realized more than a 100% gain in the past year. The recent stock market pause enables investors to re-assess conviction levels in housing-related strength.

The second controversial theme from last decade relates to China. This is a tricky theme that has seen explosive development, but for all the growth talk, the Chinese index (FXI) peaked in 2007, way before the noticeable economic pause that’s been debated for the majority of 2012. For a while, the hard landing was greatly feared and over-discussed. Recent data points to a softer landing and increasing investor demand. “They [Investors] have pumped nearly $4 billion into Chinese equity funds in the past two months alone, trying to get in early on what they hope will be a sustained rally.” (Reuters, November 25, 2012). Increasing investor demand makes sense since the Chinese markets are relatively cheap and the momentum from last decade has yet to evaporate. Nonetheless, popularity is no guarantee of price appreciation – a point for speculators to reassess.

Down the stretch

The S&P 500 index is up 12% on the year, showcasing that despite outflow in equity markets, finding returns is attractive. Fragile conditions in the credit and banking sectors persist, and the system at times feels clogged. In recent months, investors have realized the attractive risk-reward in US financial services even beyond housing. According to Factset: “two of the stocks that received the most interest [from the largest 50 hedge funds] during the quarter included AIG and Capital One Financial Corp.” (November 19, 2012). There is momentum that favors a continuation of a collective rise in key asset prices for now. Of course, companies are lowering earning guidance and sustaining the recent run is not an easy task when skepticism keeps building. Nonetheless, the months ahead will provide more clues while potential short-lived shocks can provide evidence on investors’ resilience.

Article Quotes:

“According to projections by HSBC, in six years’ time the United States will be more dependent on imports from Mexico than from any other country. Soon ‘Hecho en México’ will become more familiar to Americans than “Made in China.”… Mexican businesses have been fighting with one hand tied behind their backs, thanks to a chronic credit drought. Lending is equivalent to 26% of GDP, compared with 61% in Brazil and 71% in Chile. The drought started with the “tequila crisis” of 1994, when a currency devaluation triggered the collapse of the country’s loosely regulated banking system. Banks spent the best part of a decade dealing with their dodgy legacy assets and were nervous about making new loans. Mexico has been one of the world’s ten biggest oil producers. The revenues of Pemex, the state-run oil and gas monopoly, provide about a third of the government’s income.” (The Economist, November 24, 2012)

“Britain's biggest pension funds have delivered deplorable performance over the past decade. New research, seen exclusively by The Telegraph, shows that 14 of the 20 biggest actively managed pension funds delivered below-average returns over this period. In total more than £62bn of retirement savings is invested in these funds. Just three of the UK's largest funds (managed by Standard Life, Zurich and Windsor Life) delivered a decent return for investors, while another three – which have a further £21.5bn invested in them – beat the average fund in their sector only by a whisker. The underperforming pensions are managed by some of Britain's largest insurers and banks, including Aviva, Scottish Widows, Lloyds, Scottish Equitable, Friends Life and Barclays. … Philippa Gee, who runs her own advisory firm, said many people pointed out that passive tracker funds were "guaranteed to underperform" because they simply returned what the market did, minus charges. Philppa stated:  ‘Fund managers have no encouragement to outperform as this would involve taking a high risk, which may not fit comfortably with the investment style of the fund in question, and they have no push from investors to perform, as the money will stay there whatever the return delivered.’ This is because the banks, salesmen and advisers who sold these pensions in the first place are, on the whole, no longer reviewing them – although some will still be collecting an annual commission payment on the back of the sale.” (The Telegraph, November 25, 2012).

Levels:

S&P 500 Index [1409.15] – Climbing back above its 200-day moving average. Attempting to stabilize around 1400.

Crude [$88.28] – Narrow range forming between $85-89 in recent trading days. Like most risky assets, crude is overcoming a multi-week decline that began in mid-September 2012.

Gold [$1734.50] – Heavy resistance at $1800 points to a noteworthy trend that catches the eyes of gold aficionados.

DXY – US Dollar Index [80.19] – Another short-lived upside move. A shift back to risky assets is most likely to cause further dollar weakness.

US 10 Year Treasury Yields [1.68%] – Since the announcement of QE3, yields are trading between 1.60-1.80% – nearly in line with their 50-day moving average of 1.70%.

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